At the Motley Fool, we favor businesses with superior operations as they are the ones that can deliver long term returns for investors. To figure out how well a business is run, we can look into a company’s return on equity (ROE). The ROE is a measure of how much profit a company generates for every shareholder dollar used in the business. While the ROE is a good measure in itself, we can go a step further to gain even more insights. Breaking the ROE down into three other ratios may help us see how well a company is actually being…
At the Motley Fool, we favor businesses with superior operations as they are the ones that can deliver long term returns for investors.
To figure out how well a business is run, we can look into a company’s return on equity (ROE). The ROE is a measure of how much profit a company generates for every shareholder dollar used in the business.
While the ROE is a good measure in itself, we can go a step further to gain even more insights. Breaking the ROE down into three other ratios may help us see how well a company is actually being run.
Breaking up the ROE
In particular, we are looking to break down the ROE into three metrics, namely the return on sales, return on assets, and financial leverage.
With reference to the equation above, the first ratio (net income divided by sales) can be referred to as the return on sales, the second ratio (sales divided by assets) is the return on assets or asset turnover, and the third (assets divided by equity) is financial leverage.
For a succinct description of the individual elements, I turn to a passage from author and analyst Dennis Jean-Jacques’s book 5 Keys to Value Investing:
“Return on sales (ROS) indicates the amount of profits a company is able to keep for each dollar that the company takes in from the sale of goods and services. Asset turnover show the amount of revenues the company is able to generate for each dollar of assets committed. Financial leverage shows investors how many dollars of assets the firm can use for every dollar of equity.”
Putting Keppel Corp to the test
Let’s put rig builder Keppel Corporation Limited (SGX: BN4) through this exercise today.
In the chart below, you can see how the three components of Keppel Corp’s ROE have changed over the past five years:
For Keppel Corp, its ROE has undergone a noticeable decline over the past five-plus years; but that said, the company has still been able to keep its ROE above a healthy level of 15%.
When we dig into the components of the ROE, we can observe that the strength of Keppel Corp’s ratio comes from its high return on sales (or net margin) and financial leverage. On the other hand, Keppel Corp has only been able to eke out an average of about 46 cents for each asset dollar employed over the past five years.
Said another way, Keppel Corp needs to keep up its net margins in order to generate a decent return for each shareholder dollar; from the five year view, we can see that the decline in its ROE is very much driven by a tightening net margin. This is certainly worth keeping an eye on for the future.
A Fool’s take
A winning stock may be found when a company demonstrates a consistent track record of generating superior value for each shareholder dollar it has at its disposal.
In this case, Keppel Corp may turn into a winning stock if the company is able to maintain its ROE over the long term. But beyond that, the Foolish investor may also want to look at the possibility of future growth that may allow the company to generate even more value.
With that, the onus remains with the Foolish investor to decide if Keppel Corp’s current share price provides an appropriate margin of safety and whether it fits into his or her portfolio.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chin Hui Leong doesn’t own shares in any companies mentioned.